The Loser's Game

I wrote this essay about a month ago for my equity portfolio management class. I thought it addresses some key issues in this business so I thought I'd share it here.

“The Loser’s Game” by Charles Ellis, is a provoking explanation of the seemingly puzzling fact that active mutual funds on average have lower returns than market benchmarks. While Ellis is correct that the market has become more efficient over time to a point where fees on average outweigh alpha, this premise inaccurately implies fund mangers are failing and misses the real goal of fund mangers. Further, he is taking this unique situation to a specific investment strategy, long only large equity funds, and then applying it beyond its implications. So while the concept of a loser’s game and its implications for active investing performance are important, they are overstated and applied too broadly.

To justify the existence of investment management, it is always relative performance that matters. Thus while it may seem important for a manger to beat the S&P, he will really only fail if he underperforms his peer funds. The misconception is that measuring him against his competition is the same as measuring him against the S&P. However, this is not the case if this class of funds does not perform to the S&P in the first place. This is the root of the fallacy since in reality mutual funds can not under perform themselves. It is true that other forms of investment compete for the capital invested in simple equity funds. Yet this becomes irrelevant as well since the individuals and institutions that choose these investment vehicles that consistently under perform market benchmarks are willing to effectively pay the prices of the fees for reasons other than an attempt at outsized gains. Much of the rational for active equity management is the comfort and knowledge that the investments and risk are being actively monitored, even if over the long run this is not productive. Thus much of the capital in this investment universe is content with such “underperformance”, which therefore is really not underperformance because it is both expected and accepted.

Ellis’s argument also overemphasizes the extent of market efficiency. There are many parts of the market, such as small caps as well as new strategies that are by nature of the lack of attention paid to them less efficient. Thus, they are less subject to Ellis’s key point that investors and mangers can no longer succeed through their own positive accomplishments. It is particularly the big caps that are so dominated by large mutual funds that exhibit the over coverage and competition that creates a loser’s game. Therefore, while still significant, like everything about there market, the concept of the loser’s game is less applicable where market efficiency breaks down.

While it is very important to consider the possibility that investor actions in the market can only hurt returns, in the end it is only one part to consider. Nothing in the market is that simple or concrete. Therefore it is more accurate to consider the loser’s game as much harder than the consensus thinks to actually deliver outsized returns that are the result of the investor’s correct decisions. Under this more realistic but still humbling perspective, the concept of a loser’s game can help small investors better understand the dynamics they are up against. Yet such an understanding may matter less to the mutual fund mangers themselves since their goals are still very different then many more speculative smaller investors and hedge funds. In effect the loser’s game is a loser’s game because those mangers who specifically are playing it are trying more to not lose than to win as that is the nature of their incentives. Thus, the loser’s game is more of a subset of the investing world then an overarching principle.